S-Corps 101 (Part 2): Should Your Business Make an S-Corp Election

S-Corps 101 (Part 2): Should Your Business Make an S-Corp Election

This is the second post in a series of posts about S-Corps. In the last post we explained what exactly an S-Corp is and in this post we’ll look at reasons you should, and should not, become an S-Corp. In the next post, we’ll give an example of how to reduce your tax bill using an S-Corp structure.

When An S-Corp Election Is a Good Move

The two types of businesses most likely to benefit from an S-Corp election are:

Freelancers who operate using an LLC or Corporation and make more than a “reasonable” salary for their given profession; and

Small businesses owned by humans (as opposed to other business entities) with small and simple legal structures.

These kinds of businesses probably meet the requirements to be an S-Corp and are unlikely to change their business structure in the future. That’s important because if you make a change to your business and fail to meet the requirements, you’ll lose your S-Corp status and may suffer serious financial consequences as a result.

After making the S-Corp election, these business will gain two primary benefits:

They can avoid paying corporate taxes on the businesses income and instead, “pass through” all the income to the owners’ individual tax returns.

They can reduce their tax bill by classifying part of their income as profit distributions. (Read more about that in our third post.)

When An S-Corp Election Is a Bad Move

However, S-Corp elections are not for everyone.

Specifically, many businesses don’t meet the requirements (for example, they are owned by an ineligible owner, have multiple ownership classes, etc.). In those scenarios, it is pretty obvious that they shouldn’t make an S-Corp election.

However, sometimes you might think an S-Corp election is advisable, but if you study your business plan, you may realize it isn’t a good move. This is especially true for high-growth potential startups that need to raise venture capital. That’s because an S-Corp can only have 100 owners (which means you can’t go public), it can’t be owned by most types of business entities (which means most VCs can’t invest in the company), and it can’t have more than one classification of ownership interest (which means you can’t grant preferred stock to your investors).

For clarification, you can always revoke (or accidentally bust) your S-Corp election to get out from the restrictions, but doing so usually results in severe, and negative, financial consequences.

In either event, you should always talk with an accountant and an attorney before making an S-Corp election for your business.

S-Corps 101 (Part 3): How To Reduce Your Taxes Using An S-Corp

In our next post we’ll give you an “easy” to follow example of how making an S-Corp election can reduce your tax liability.

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Image: Adobe/TeddyandMia

*This article is very general in nature and does not constitute legal advice.